Despite being a well-known tool with no more secrets,
financial leverage still represents a hot topic. It often generates heated discussions between supporters and detractors. Some recommend it, while others abhor it, considering it a dangerous instrument always and in any case.
It's worth taking stock of the situation, keeping in mind the
risks that the use of financial leverage exposes.
We will do this in this brief but exhaustive guide, which will conclude with some advice for the "brave" who intend to use financial leverage anyway and with a reflection on the types of traders who should avoid it in any case.
What is financial leverage
Financial leverage is a tool that allows you to increase exposure in the markets, going beyond what is the capital actually allocated. We could define it as a sort of multiplier. The main problem is this: it is a
multiplier of gains, but also of losses.
The functioning is simple. You choose a leverage ratio among those made available by the Broker, usually represented by the formula X:1, where "X" means the multiplication coefficient. After that, you operate... Hoping that everything goes well.
But let's make an
example. If you trade with a leverage of 50:1 and allocate 1000 euros in a single trade, you will generate effects identical to a trade for which 50,000 euros have been allocated.
This means that in the case in which a gain equal to 2% was totalized, a gain of 1000 euros would be obtained, equal to 100% of the capital actually invested. It goes without saying that in the case in which a
loss of equal entity was totalized, this would concretize the loss of the entire investment.
It is not surprising therefore that
financial leverage is considered a controversial instrument. Indeed,
in Europe it is heavily
limited. Yet, there are those who still crave its use. The reason is simple: when they work - and we emphasize "when" - they impart an extraordinary acceleration, generate a
dramatic increase in capital.
Some markets push for the use of leverage more than others. For example, those that in one way or another impose high entry barriers, which force slow growth or which, on the contrary, stand out for volatility. In the first case, leverage - we repeat,
when it works - allows you to compensate for generally limited profit margins. In the second case, it allows you to fully exploit volatility.
Against these few advantages, there is a plethora of
risks such as to push even the most experienced trader to think twice before using leverage. We talk about it in the next paragraph.
The risks of financial leverage
So, what are the
risks of financial leverage? Here are the most serious ones, those with the greatest probability of becoming reality.
- Ending up on the street. It may seem like a strong expression, but the risk is exactly this. We must not forget that leverage multiplies gains but also losses. Now, losing is physiological. Trades fail. It's all about containing losses. Well, financial leverage makes it extremely difficult to contain losses, to bring them to an acceptable level. Hence, the risk of losing all the capital, or at least a substantial part of it.
- Automatic closing of the position. All Brokers implement safety measures to prevent the trader from going "too much in the red", or from losing so much as to cause problems for the broker himself. Therefore, they tend to close losing positions if these are further aggravated by leverage and reach certain requirements (which vary from Broker to Broker).
- Triggering dynamics akin to gambling. With leverage, you earn a lot and, above all, you lose a lot. Above all, it is little controllable. Excess and lack of control are typical elements of gambling. Therefore, using leverage could subject the trader to the typical dynamics of gambling.
How to manage financial leverage
Yet
financial leverage can be
managed. With difficulty, but it can be controlled
at least a little, in order to limit the damage and increase the still scarce probability of profit. Here is some advice.
- Understand the risks. It may seem paradoxical, but the most useful advice is just this: knowing all the dangers of leverage, its technical and psychological drifts.
- Use low ratios. It is an apparently trivial advice, but it cannot be disregarded. Only "soft" leverage, those that do not go beyond 50:1, can be controlled, or at least they pose the possibility, albeit remote, of control.
- Use loss containment techniques. Again, it may seem a contradiction, but if on the one hand you use leverage, on the other it is absolutely necessary to set up tools that can force the exit from the market, under certain conditions. Above all, the stop loss.
- Frequent monitoring. Monitoring is a practice to be implemented always and in any case, but in this case it assumes a blatant importance. Leverage, precisely as a multiplier, can generate extreme losses in the time span that separates one check from another. Therefore, these must be extremely close together.
Who should avoid financial leverage?
We close with a reflection on the types of trading that should
avoid financial leverage. Certainly, inexperienced traders who have not acquired the technical and psychological skills to manage such a controversial tool. The same goes for experienced traders, but who have not yet reached a level of excellence. If they are competent, and therefore already earn, they have no reason to put their capital at risk. Finally, all traders whose personality is prone to anxiety should avoid financial leverage. You will have understood: financial leverage is extremely anxiety-provoking, since it exponentially increases the stakes.
So,
who should use financial leverage? Indeed, who
can use it? Basically, only top traders, who if they cannot be counted on the fingers of one hand, there is little missing. Only they have the sufficient technical and psychological background to transform a time bomb into a tool to earn.
